RATIO ANALYSIS

[Mr. M. GOVINDARAJAN]

INTRODUCTION:

A company is incorporated for running a business with certain objectives with the ultimate aim to maximize the wealth of the shareholders, the survival of the business etc.,   Finance is the common threat that runs across all areas of a business.   A modern business enterprise has to meet the aspiration of various interest groups such as shareholders, employees, customers, creditors, government and society in general.   While some of the aspirations are financial in nature while the other are not.

FINANCE:

                        The terms Finance, Finance functions and Financial Management are used interchangeably for the discipline related to managing of money matters.   All the activities of the business are measured in financial terms.   The Financial Management involves raising funds, putting the resources to efficient use through effective financial planning, financial organization and financial control to deal with tastes like ensuring the availability of funds, allocating them for different uses, managing them, investing funds, controlling costs, forecasting financial requirements doing profit planning and estimating rate of return on investment and assessment of working capital etc.,

                        Financial statements are statements containing the information about reporting performance and financial position of the business concerned.   In India, financial statements of corporate bodies comprises of Profit and Loss Account, balance sheet and schedules and notes forming part thereof.   Financial Statement analysis refers to the judgment process which aims to evaluate the current and past financial positions and the results of the operations of the enterprise.

RATIO ANALYSIS:

                        The Ratio Analysis stands for the process of determining and presenting the relationship of items and group of items in the statements.   A ratio is a statistical yardstick that provides a measure of relationship between two accounting figures, and which two figures should be compared with each other depending upon the purpose of comparison.   The purposes may be as under:

 ·  To examine the ability of existing assets to generate additional funds;

·  To examine the adequacy of profitability;

·  To assess the ability of the business to meet its current obligations;

·  To evaluate the debt-raising capacity.

Ratio analysis was introduced by Alexander Wall in the year 1919.  The following users require an analytical view of financial statements:

·  The shareholders including existing and potential shareholders - to examine, to buy, sell or to hold the existing shares;

·  Creditors - to assess the economic condition of the business;

·  Business contact groups - customers, trade creditors, supplier to appraise the future of the enterprise to assess the reliability of the business;

·  Government - for taxation, information etc.,

·  Employees - for collective bargaining and for assessment of job security;

·  Financial analysis.

The above said list is only illustrative and not exhaustive.

USES OF ACCOUNTING RATIOS:

 ·  The performance and financial position can be easily judged by working out of the accounting ratios, which may be done through comparison:

Ø      For the same form over a period of years; or

Ø      For one firm against another; or

Ø      For one firm against the industry as a whole or against pre determined standards; or

Ø      For one department or departments of a firm against the other divisions or departments of the same firm.

·  The Accounting Ratios not only indicate the present position, but also indicate the causes leading into the position to a large extent;

·  Accounting ratios tabulated for a number of years indicate the trend of change;

·  Accounting ratios help in preparation of estimates for the future;

·  Accounting ratios help in forewarning corporate sickness and helps the management to take corrective action;

·  It helps in investment decisions in the case of investors and lending decisions in the case of bankers and financial institutions.

EXPRESSION OF ACCOUNTING RATIOS:

Accounting Ratios may be expressed by-

 ·  Pure ratios - eg., current assets to current liability = 2:1

·  Rate which is the rate between two numerical facts, usually over a period of time - eg., stock turn over is three times a year;

·  Percentage - eg., gross profit is 25% on sales.

CLASSIFICATION OF RATIOS:

                        There are three ways of classification of Accounting Ratios.   One way is the classification based on the statement which the ratios are calculated which are-

 ·  Balance sheet ratios based on balance sheet figures;

·  Profit and loss account ratios based on profit and loss accounts;

·  Balance sheet and profit and loss rations based on both statements.

The second way of classification is from the angle of users such as shareholders, creditors etc.,

The third way of classification is based on their functions such as profitability ratios, solvency ratios etc.,

STANDARDS FOR COMPARISON:

                        There must be some standard ratios with which the actual ratios can be compared, to have an effective ratio analysis.  There are four types of standards which are as follows:

 ·  HISTORICAL STANDARDS - They are the past ratios of the firm.   Present performance of the firm can be compared with that of the past ratios and inference can be drawn on the improvement or of a particular aspect.  These standards are not satisfactory.   If we take operative ratios of the past as the standard, the present inefficiency is merely compared with the past inefficiency;

·  ABSOLUTE STANDARDS - They are decided by the rule of thumb.  For example, the case of current ratio 2:1 is desired for a firm.   The actual is compared with such standard.   There are also limitations of such standards.   As such this standard is not an ideal one;

·  HORIZANTAL STANDARDS - These are the average ratios calculated for the entire industry or the ratios of some other firm engaged in the same line.   In using this standard there is a difficulty.   No two firms are similar in size, having the accounting policies and corporate objectives.   So there will be significant differences between the standard adopted and the actual ratio;

·  BUDGETED STANDARD - These standards are based on budgeted figures.   The actual ratios are compared with budgeted ratios.

LIMITATIONS:

 ·  Accounting ratios can be only as correct as the data on which they are based;

·  When two firms are compared difficulties may arise due to the adoption of different accounting policies etc.,;

·  Changes in price levels often make comparison of figures for various years, difficult;

·  Accounting rations may be worked out for any two figures even if they are not significantly related.   Such ratios will only be misleading.   So care should be there to work out only significant ratios;

·  Ratios some times give a misleading picture.   It is, therefore, useful if, along with ratios absolute figures are also to be studied; unless the firms being studied are equal in all respects.

CARE IN USE OF RATIOS:

To get better results ratio analysis is to be done with care since several factors affect the efficiency of the ratios:

 ·  Type of business which is taken into consideration;

·  Seasonal character of the business affects the ratios for a particular type of industry or business enterprises;

·  Quality of assets also affect the ratio analysis and gives different interpretation to different business enterprise;

·  Adequacy of data is another consideration for comparison of a particular factors with each other;

·  Modifications of rations reflect only the past performance and must be modified by future trends of business;

·  Interpretation of ratios should not be relied upon isolation and should be considered with accounting documents for interpretations;

·  Non financial data ratios based on financial data of firms should be considered with non financial data to supplement the financial ratios and give better interpretation.

VARIOUS RATIOS:

Balance Sheet ratios:

1. Current ratio or working capital ratio;
2. Liquid ratio or quick ratio or acid test ratio;
3. Proprietary ratio;
4. Assets-proprietary ratio.

P&L Statement Ratio:

1. Gross Profit Ratio;
2. Operating Ratio;
3. Expenses ratio;
4. Net Profit ratio;
5. Stock turn over or turn over of inventory;

Balance Sheet & P&L Ratios:

1. Return on total resources;
2. Return on own funds;
3. Turnover of fixed assets;
4. Turnover of debts;
5. Earning per share.

RATIOS FROM SHARE HOLDER'S POINT OF VIEW:

1. Earning per share;
2. Diluted Earning per share;
3. Price Earning per share;
4. Capitalization rate;
5. Pay-out Ratio;
6. Dividend Yield Ratio;
7. Profitability Ratio -

   I.  Sales Ratios:

a)      Sales/Fixed Assets;

b)      Sales/Total Net worth;

c)      Sales/Working capital.

   II.      Expense Ratios:

a)      Factory Expense/Sales;

b)      Administrative Expenses/Sales;

c)      Sales Expenses/Sale.

   III.      Profit Ratios:

 a)      Gross Profit Margin;

b)      Net Profit Margin;

c)      Operating Ratio;

d)      Return on Investment;

e)      Return on assets;

f)        Return on equity.

 RATIOS FOR SHORT TERM CREDITORS:

1. Liquidity ratio - Current Ratio; Acid Test Ratio;
2. Movement of current assets ratio:

a)      Stock turn over ratio;

b)      Debtors turn over;

c)      Collection period;

d)      Average debtors.

 RATIOS FOR LONG TERM CREDITORS:

1. Debt-equity ratio;
2. Debt Ratio;
3. Coverage Ratios:

a)      Interest coverage ratio;

b)      Fixed charge cover ratio.

The following table would help to calculate the required ratios:

 

Sl.No.	Objective of Analysis	Ratios to be computed
1	Short term financial solvency	1. Current Ratio
		2. Liquidity Ratio
2	Long term financial solvency	1.Equity or Proprietary ratio
		2. Debit Ratio
		3. Debt Equity  ratio
		4. Share holders equity to total equity ratio
3	Immediate solvency	Liquidity ratio
4	Overall Efficiency	1. Return on Investment
		2. Operating Ratio
		3. Assets turn over and other turn over
		ratios
		4. Return on proprietor's equity
		5. Earning per share
5	Profitability in relation to sales	1. Gross profit
		2. Net Profit ratio
6	Profitability in relation to	1. Return on Investment
	investment	2. Return on proprietor's equity
		3. Earning per share
7	Over trading or under trading	1. Proprietary ratio
		2. Current Ratio
		3. Stock turn over ratio
8	Trading on equity	Capital gearing ratio
9	Over capitalization and under	1. Proprietary ratio
	capitalization	2. Current Ratio
		3. Return on equity capital
10	Operating Efficiency	1. Operating Ratio
		2. Expense Ratio
11	Diagnosing insolvency	1. Profit before tax to current liabilities
		2. Current assets to total liabilities
		3. Current liability to total tangible assets
		4. No credit interval which is the ratio of
		working capital to operating costs
		excluding depreciation.